Companies like Facebook are allowed to treat the cost of non-cash compensation, such as stock options, as an expense that reduces profits, essentially the way they treat cash compensation such as salaries.

From the OP link.

Financial accounting reports are done on an accrual basis, i.e. you mowed a lawn in February, but get paid in March, you recognize the revenue in February.

The IRS allows businesses to report tax liability on a cash basis, i.e. you cut shovel snow in December 212, you get paid in January 2013, you don’t recognize the revenue in 2012 for tax purposes, but you can recognize it for financial reporting purposes to banks, etc.

Very over simplified, but stock-options aren’t treated as expenses for financial reporting purposes, but they can be treated as cash payments for tax reporting purposes.

Stock option accounting has been set up as an area for a lot of abuse in financial reporting, but that’s another issue.

Also, too part of the issue is that tax law and accounting standards are usually set by different agencies.* Congress sets tax laws. Congress delegated setting accounting standards to the SEC, who delegated it to FASB, which is a private independent organization run by accountants.

The difference between, who sets tax and accounting laws/standards is one reason pre-tax profit doesn’t translate to tax payments.

*In the mid-1990’s, FASB wanted to have stock options treated as expenses and reported on the financial statements. Agency theory had been going on for over a decade and CEO pay, via stock options, had been shooting up.

Businesses lobbied heavily for Congress to step in. Since FASB exists by the good graces of the government, they backed down and changed their decision and allowed stock options to only be disclosed in the footnotes and not treated as an expense item.

The real tax experts can probably explain it better than this, but this is a very general overview.

@dr. bloor: Yeah, one of my neighbors edits the WaPo’s Sunday magazine and thinks getting rid of the ombudsman is a bad idea but says it’s all about the latest round of cost cutting. The Kaplan Test Prep Daily is getting hammered in profitability or at least profit expectations so I see the paper continuing its long slide toward eventual irrelevance.

Here’s my solution to this particular loophole: require the first page of a companies prospectus to show the profit/loss that they declared to the IRS.

This particular scam isn’t only ripping off the taxpayers. It’s a way to scam prospective investors. They pay low salaries (in relation to total compensation) and large stock payouts. The stock prospectus can then show how lean and mean they are, hardly paying out any cash at all, perhaps even looking as if they turn a profit. Then when the IRS comes along it turns out they’re not profitable at all.

I’ve argued this again and again when I’ve worked in startups. You’re always told that no, of course we’re not defrauding investors. You see, everyone on Wall Street is super duper smart and would never actually believe all the bullshit on the front of the prospectus without reading the rest of it. Yet if you suggest that you put the information that they’re going to dig out anyway on the cover people seem to think they’ll have a harder time finding investors.

Thanks for the overview. I’m sure there are a lot of corporate loopholes in the tax code. I just can’t tell if this is one, or if it’s a quirk of an otherwise legitimate difference in accounting systems.

Typical. Wage slaves simply don’t have the many options available to people who get a bunch of different ways to get paid, from charging new additions, redecorating, and housecleaning with their corporate account to going anywhere they want on the corporate jet.

And yet, with everything they have, they want more. It’s pathological.

Here’s my solution to this particular loophole: require the first page of a companies prospectus to show the profit/loss that they declared to the IRS.

Wouldn’t deter investors.

Per IRS rules, depreciation schedules of capital items – cars, factor equipment, computers, etc. – are fixed and usually set up on an accelerated depreciation schedule, i.e. you depreciate more in the first year and the least in the last year, with each year inbetween depreciating less than the first year, but more than the last year.

Per financial reporting standards businesses are free to pick any method of the depreciation that is acceptable. They can do straight line depreciation – depreciate the same amount every year for the useful life of the asset – for example.

This leads to differences in capital intensive companies between book profits versus tax profits.

Showing you have lower tax profits than book profits wouldn’t really reflect badly on a company, because the differences don’t reflect the underlying performance of the company.

They just show different treatment of an accounting rule.

The only way to get around this is via some act of Congress, but given how little Congressman know about things like tax law, the “fix” may cause as many problems as leaving things alone.

What most people view as “corporate loopholes” really is based on the differences in tax laws and accounting standards.

No doubt. The more precise question is whether the tax law accounting standard at issue is supported by a legitimate economic or tax administration rationale, or whether it simply implements a taxpayer subsidy to a company or industry sector.

Here’s my solution to this particular loophole: require the first page of a companies prospectus to show the profit/loss that they declared to the IRS.

Honestly, anyone who relies on a profit/loss statement to determine how a company is doing is in trouble to start with. You’re in much better shape by going straight to the balance sheet and see how that’s changing over time.

@Roger Moore: The balance sheet is not enough, because that just gives you the long term picture. You need to seed the Income statement (to see how much of their income is from operating activities) and the Statement of Cash flows. To see how liquid they are and how much cash they have on hand. In fact I would say that they are more important than the balance sheet.

IIRC, stock options as compensation were pioneered by early Silicon Valley startups as a way to lure experienced corporate leaders without having to pay them big cash salaries and taking advantage of a tax loophole where they didn’t have to report the compensation as a traditional expense. The rest of the corporate world quickly caught on to the game and soon it became a pretty standard way of bulking up executive compensation in virtually every industry.

I’m not a CPA, but how about limiting the tax advantage of stock options to say five years after a company goes public? Give small startups a chance to recruit people with stock options, but phase them out over time. After that, you have to declare salaries as salaries.

@gene108: By definition, if you don’t keep wanting more money than you can possibly have any practical use for, you will never become a billionaire.

I have to disagree, a bit.

People can become quite rich by juxtaposition; what they are passionate about doing anyway becomes popular and the multiplier effect makes them wealthy. Musicians and writers don’t go into their fields with dreams of wealth; not if they have any sense. Becoming a corporate shark is a much more reliable means, and requires little in the way of actual talent.

But yes, greedy people tend to accumulate money. Because it is all they care about, they can never have enough. I remember when Martha Stewart became prominent; I believe the stories that say she sleeps only a few hours a night and is always pointed towards profit. Such a person has a LOT more chances to get rich than say, me.

@jonas:
It’s not just experienced corporate leaders who get options in startups. It’s fairly common to pay nearly everyone at the company at least partly in stock or stock options. It gives early employees some sweat equity in the company and is supposed to help give them a bigger incentive to make it succeed.

I honestly think that company stock plans should be encouraged as long as they cover the whole workforce rather than just the people at the top. They give employees a real stake in their companies and help to encourage the kind of loyalty that companies are always complaining has disappeared these days. My impression is that the companies that are still well known for extreme loyalty almost all have those kinds of company stock plans, and I don’t think it’s a coincidence.

As a C-corp, Facebook has the right to carryforward losses with debts they racked up when they began the company. That’s one of those “innovation incentives” or “risk incentives” you receive in the tax code. They basically ran at significant losses for a few years and can carryforward the loss for 20 years (or until they use it up).

Stock options are treated as wages, so they’re taxed at the individual’s wage rate and not the capital gains rate. If then individual sells the stock, they are taxed at the capital gains rate of the difference between their basis and what it sold for.

Basically companies keep two sets of books – one set by the accounts (GAAP accounting) and one for the IRS (tax). This isn’t nefararious, its just that on some things accountants have one view and the accountants another.

On stock options, there is a difference between tax and GAAP. Let’s walk through a simple example. Your company’s stock is trading at $20/share, and in 2012 the company grants you an option to buy 100 shares at $20/share for a job well done. In 2013 the stock is trading at $30/share, you go to your boss and give him $2000 ($20 option price for 100 shares) then immediately sell the shares for $3000, netting you a $1000 profilt.

The accountants would say that there is a cost to the company for giving you the option in 2012 since there is some value in that option i.e. there is a non zero chance your stock goes up and you can buy the stock cheaper (the formula is complicated but is basically the Black Sholes option pricing model for most companies). Let’s take as given that the accountants determine the cost is $200 as that is the value of the option. Your company deducts $200 (basically as compensation expense) when it determines its profit for the accountants.

For the IRS, the grant is not in cash and IRS works more on the cash method. So while the accountants say this is worth $200, the IRS says it is nothing. When you excercize the option, there is a cost to the company – essentially $1000 as they are selling you a share of stock valued at $30 for $20. You on the other hand have a $10 profit since you got something worth $30 but paid $20.

So, for the accountants, the only expense Facebook had was granting 100/shares per person in 2012 (or whatever the amount was) while for the IRS Facebook was unprofitable as all those options excercized around the IPO created a large loss for the company. However this is offset by a large amount of income for Facebook’s employees.

Musicians and writers don’t go into their fields with dreams of wealth; not if they have any sense.

There’s a difference between millionaires and billionaires. Some actors, sports professionals, writers, musicians, etc. get rich because of their talent and become millionaires.

To become a billionaire takes a level of focus towards accumulating wealth beyond just cashing in on your talent, athleticism, looks, etc.

Becoming a corporate shark is a much more reliable means, and requires little in the way of actual talent.

I disagree.

There’s a lot of work, sacrifice and struggle to advance in the corporate world. There’s a certain level of talent to be able to mingle with people and do what’s needed to advance a career.

Probably the biggest difference is that with artists and athletes, most of them are successful by 30 or they aren’t going to be big-time. A few male actors are the exception, like Samuel L. Jackson and Bradley Cooper, but musicians, athletes, female models and actresses usually strike it big in their 20’s or aren’t going to make it.

You get to see raw talent in those cases reach the pinnacle of success at a young age.

In the corporate world you pay your dues and usually work to move up the food chain, so what natural talent people have gets honed by work and may not be as obvious.

There is a ton of bad information in these comments. Let me see if I can straighten some of it out.

(1) The way the tax rules for stock-based compensation work is roughly as follows: in general, when an employee exercises a stock option, the employer gets a deduction equal to the “spread,” I.e., the difference between the fair market value of the stock on the date of exercise and the exercise price. When a successful tech company files for am IPO, it’s to be expected that employees who were given cheap options in lieu of cash compensation will exercise and cash out. It’s not unreasonable to use the IPO price as a proxy for the value on any date between the announcement and the completion of the IPO. The result is a huge slug of compensation expense right around the time of the IPO. You can argue that it would be more consistent with the principles of the accrual method of accounting to spread that cost back over the period during which the services were performed, but no one has yet come up with a reliable way to do that.

(2) Net operating loss carry-backs and carry-forwards have been part of the income tax for as long as there has been an income tax. The idea is that rigid adherence to annual accounting may result in a mismatch between the actual performance of an enterprise over time and the net of annual results.

(3) with respect to the interaction of (1) and (2), Facebook pretty clearly did nothing wrong. That’s the way it works. If you don’t like it, your beef is with Congress.

(4) That is not to say that Facebook hasn’t taken other aggressive steps to optimize its worldwide effective tax rate. There are a lot of things that multinational companies can legitimately do to earn income in relatively low-tax jurisdictions. There are also things that companies can do that push the envelope to the limit. I don’t know, and I’m not going to speculate.

It should be noted that, as with most differences between financial reporting and tax reporting, in the long run the difference between the results will be negligible if not zero. It affects the timing of when income(losses) is recognized but not the eventual outcome. In this case you’ll have to dig into some of the owners’ equity accounts to find it but it will be there.

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